I was recently reading a profile article on a financial website that made me cringe. The article was profiling a somewhat young (mid to late 30’s) investor with only about seven years of real investing experience (2008 through 2015). I could tell that the investor was serious about wealth building, was a very good saver, and very proud of their discipline. It was great to see a younger person exhibiting the behaviors of success and implementing good financial habits.
Within the profile article the investor was quoted as saying, “I’ve had good returns and based on my investing, I will be “here” in wealth in just two or three more years.”
What made me cringe was the likelihood of an impending hard lesson on investing due to some very common investing mistakes made by most investors (especially those who are younger in age).
Here are 3 critical lessons that every wealthy investor learns at some point during the wealth building process (hopefully sooner rather than later before really big money is on the line);
- Recency bias – Recency bias is the tendency to predict the future based on events in the recent past. The investor profiled in the article was joyfully expressing their pleasure of investing over the past 7 years (which happens to be one of the most unusual upward moves in the stock market’s history). Their point of entry was in 2008, just prior to the bottom forming in early 2009 when they had little money to invest. Over the next few years, each and every time they saved and invested they were quickly rewarded with escalating asset prices. The investor is now programmed to believe that asset prices only go up and up. They have no other perspective because they are basing their beliefs on their own recent life experiences. Projecting the same upward movements over the next few years (or for the remainder of their career) will probably throw this investor for some hard emotional times because they won’t know anything other than their own immediate success and recent results.
- No knowledge of longer term secular cycles and history – Most investors completely fail to realize the longer term cycles that play out in secular movements. We are not talking about business cycles that last from 3 to 5 years but rather secular economic cycles that could last far longer than a decade or two. Examples include the Dow Jones Industrial Average (DJIA) at 78.26 in 1901 and again at 78.59 in 1922 (21 years later). Or the Dow Jones at 381.17 in 1929 and finally passing that level again permanently in March of 1954 (24 ½ years later). Many investors are good about believing, “Oh don’t worry, stocks will always go back up in the long run,” but that has to be kept in perspective because in the long run, we are all dead. Investing is about understanding your true time horizon because you’ll need high probabilities that stock prices will be higher when you actually need the money, not just “at some point in the long run.”
- Understanding how mathematical averages really work – One behavioral issue that investors carry with them is an entitlement mentality on average or above average returns. If markets are doing well, they expect “above average returns.” But if markets are not doing well, they still expect to do better than the averages (and thus again, “above average returns.”) But that’s not how the totality of financial markets work through full cycles. If investors get fixated on a historical performance number such as, “stocks go up on average 9.5% a year” then in good years they want double digit returns and in bad years they still feel entitled to positive single digit returns. Emotionally, they can’t handle the realities of market volatilities which often result in large negative return years so that over time, the averages still work out over time periods that are measured in multiple decades, not just 5 or 10 years.
Understanding these critical lessons may end up saving you a lot of money and emotional grief as you progress through your wealth building journey.